The working poor are burdened with some of the most complex tax returns in the country as they annually claim Earned Income Tax and Child Tax refundable credits. In the coming months, low- and middle-income Americans who received unemployment insurance payments during the Covid-19 pandemic may also face a “tax trap” that unexpectedly reduces their EITC benefits. At the same time, some have advocated that the IRS core mission be substantially expanded beyond their traditional role in society. But the emerging environment tells us something important about the complexity of our tax system, and the societal costs of pushing the IRS to do too much.
October 15th is the final tax deadline for the 2019 Tax Season, but it also the last normal Tax Day that Americans will have for a while. Someone who filed for an extension to their 2019 taxes will have their return due on that day. But next year’s tax return, for Tax Year 2020 when it comes due in 2021, will reflect the utter chaos of our collective 2020 experience.
Many Americans will be dealing with a much different tax situation than they expected at the beginning of 2020. If they worked remotely from a different state than their office, it’s entirely possible that many workers may end up paying taxes to two jurisdictions. If they lost their job, their earned income from work might be less, while their unemployment benefits might be higher. For too many unfortunate people the pain of a Covid diagnosis will be accompanied by much higher medical expenses. All of these factors, and more, will lead to a 2021 Tax Day more painful and burdensome, and carrying greater risk, than usual for millions.
Facing particularly big problems in their Tax Year 2020 returns are the low- and moderate-income Americans who might qualify for the earned income tax credit (EITC). The EITC, along with the Child Tax Credit (CTC) is one of the nation’s most important anti-poverty programs. The EITC refundable credit alone provides as much as $6660, depending on income and number of children. As of December 2019, the EITC paid out $63 billion to 25 million Americans. Roughly 85% of that total went to taxpayers with adjusted gross incomes (AGI) of less than $30,000.
The importance of the EITC and the CTC cannot be overstated. In 2018, the EITC alone lifted about 5.6 million people out of poverty, including about 3 million children. But the problem is that the EITC has an extremely complicated set of rules and requirements about who is eligible and how much money they can receive, based on a combination of earned income, adjusted gross income, number of children, familial relationships, who lived with whom for how long, the composition of the family unit, and more. Individuals who violate any of these rules can have the tax credit taken away and may be banned from getting the credit for years.
Beyond this tax complexity that is always faced by working poor and moderate-income taxpayers, the returns due in 2021 are looming on the horizon as a daunting challenge for this population. A September 2020 report from the Tax Policy Center argues that recipients of the EITC will face a potentially large and unexpected Covid-related tax trap when they do their Tax Year 2020 returns. It turns out that the hundreds of billions of special unemployment insurance benefits received during the pandemic––so needed by those affected by pandemic loss of jobs—count towards overall income for tax purposes, but do not count as “earned income” for EITC purposes. Because of the complex EITC rules, observes the TPC report, “receiving UI benefits can decrease the EITC, but cannot increase it.”
This Covid tax trap may unexpectedly reduce the EITC credit for many low-income families when it comes time to file their next taxes—an unwelcome surprise for people that are already struggling with the financial and health impacts of this pandemic. That’s a special problem, says the TPC report “since research shows low- and moderate-income families plan for that annual tax refund.”
Advocates of a return-free tax system have long contended that the IRS already has all the information it needs to prepare the returns for low- and moderate-income taxpayers. So in this real-world scenario, could the IRS use the information that it already has to help low- and middle-income Americans figure their EITC refund in this very complicated pandemic year, without the taxpayer having to struggle through all the rules and calculations to prepare their own return, or get professional help to qualify for refundable credits and determine the refund due to them?
The short answer is no. The IRS does not have the necessary information in its databases to accurately determine a low-income taxpayer’s eligibility for EITC and/or correctly calculate the amount of credit due to the taxpayer—indeed, far from it. The EITC is based on a stew of residency, family relationship, and income limits, with complex tie breaker rules. And like a giant puzzle, it requires deep knowledge of the personal lives of people living in the same household or family unit, with who else, for how long, and what their relationships and incomes are, just for a start. If a child qualifies to be claimed for EITC purposes by more than one person, there are six tie breaking rules. Single parent households, and the non-traditional makeup of today’s household relationships, have also evolved in modern society faster than government regulations can keep up.
And especially when there are dramatic shocks to the economy—such as the health crisis of 2020, or a severe natural disaster or climate change event, or a future large-scale economic dislocation—there’s no way to use the previous year’s information as an accurate guide. Moreover, no information return is automatically generated that says whether a child is living with their grandparents while their parents do essential jobs around the clock. And unique household or family circumstances are equally challenging given the velocity of domestic changes in today’s society, or in coping with crisis as we have in 2020. For example, the IRS does not automatically receive reports of split custody divorces where the children spend more than half of 2020 at the one parent’s house which had better broadband connections for school purposes or had broadband at all.
Suppose the next administration wanted to help out low- and middle-income Americans by estimating their EITC for 2020 and 2021. It would be a massive and costly undertaking for the IRS to go out nationwide to even try to collect and process the necessary extensive personal data on individuals, households and families to even begin to have enough information to even attempt to accurately determine eligibility for EITC and calculate the credit payment. To put this in perspective, the ten-year cost of conducting the 2020 Census is in excess of $15 billion. However, calculating the EITC actually requires collecting annually much more personal information than even the decennial Census. Moreover, part of the reason that the Census is so expensive is to track down precisely the low-income population that is eligible for the EITC.
Why so expensive and mammoth an undertaking? The rules for which taxpayers get to claim a child for EITC purposes depends crucially on who the child lived with during the year, and for how long. In other words, the IRS would need to know for each potential claimant—including grandparents and aunts and uncles in a multigenerational household, and whether and how household or family makeup changed or evolved during the year—and how many months each child lived there and with whom. In addition, the rules require information on adjusted gross income (AGI) per potential claimant.
The IRS already has a Dependent Database which helps it determine if two or more taxpayers have claimed the same child after they have filed, as part of tax administration. But the database does not have the prospective information to determine which person is the right one to make a claim for EITC before filing, much less accurately determine the amount of refund credit that the taxpayer will be due.
The only place this information can come from is the potential EITC recipients themselves. The data would have to be voluntarily submitted by the taxpayers themselves in advance of the government being able to attempt to accurately prepare the tax return for the taxpayer. That means they would have to fill out new data collection forms in January, either online or on paper, which would compile the necessary information about where the child or children resided, with whom, for how long, the relationships to the children and among household or family members, and the varied incomes of those individuals in the household. Indeed, expansion of the IRS into the function of annual collection of extensive personal nonfinancial data about individuals, households and families might very well receive bipartisan outcry, for any number of public interest reasons ranging from fiscal cost to the impact on personal privacy. The task each year would be huge.
Oddly enough, low- and moderate-income taxpayer returns that claim the EITC have been repeatedly described as “simple” returns by advocates of having the IRS take over tax preparation. But a study by the Tax Policy Center highlights the sheer complexity of low-income tax returns, noting that
…eligibility for child benefits has increasingly relied on the concept of a tax unit, which has not evolved with families…. The income tax law is based on annual filing and bases the definition of a filing unit primarily on legal relationships, child residency, and support. Consequently, families that change throughout the year may have difficulty correctly determining their filing status and who can properly claim a child for the purpose of receiving child-related benefits.
As the TPC study observed, “[b]ecause of these changes in family structure, tax filing has become more complex for many and will likely continue to grow more complex.”
The reality is that the IRS already collects 3.5 billion information returns each year, but most of them are generated automatically in the course of doing business by companies, such as employers and financial institutions. Out of the 3.5 billion, for example, 2.3 billion are 1099-B forms for reporting securities transactions, which are tracked by brokerage firms as part of doing business. These forms are then delivered electronically to the IRS ready to be processed.
In contrast to the billions of electronic reported information forms, the IRS only processed 40 million paper information forms in FY 2019 and has been trying to drive down that number even more, as it continues its long-term modernization toward electronic tax operations originally begun back in 1998 as result of the work of President Bill Clinton’s National Commission on IRS Restructure and Reform, and its implementing Act. Shifting resources to a massive new data collection function to obtain the kind of personal data required to establish eligibility for the EITC, would require the IRS to go in the opposite direction and set up an entirely new set of workstream and systems for electronic and paper submission of “pre-return” personal information returns. In the best-case electronic scenario, that would include creating and maintaining a significant new online user interface for entering details of children, residency, relationships, and potential claimants.
Indeed, the United Kingdom offers a real-world case study of exactly this problem, based on their difficult experience with the UK version of the EITC, the Working Tax Credit, introduced in 2003. According to a study by the All-Party Parliamentary Taxation Group, a non-partisan committee of the UK parliament, the government figured out the hard way that it simply did not have enough information to accurately determine family tax credit eligibility, despite the fact that Her Majesty’s Revenue and Customs (HMRC) had long run a classic ‘return-free’ tax system for blue-collar taxpayers.
In response, the HMRC mandated the annual preparation and filing of a multi-page “pre-return” by taxpayers to establish their eligibility for the Working Tax Credit. This pre-return, resembling an old-fashioned, multi-page American 1040 tax return, provides the government the extensive personal information it needs for the government to prepare the taxes for the taxpayer– so the taxpayer doesn’t have to file a return. This tortured logic illustrates the problems that low- and middle-income taxpayers in the U.S. would face if the IRS followed the UK example, held up by return-free advocates as the state-of-the-art model to follow to reduce taxpayer burden.
How much would it cost to expand the IRS Dependent Database on short notice, in order to collect the significant additional information necessary, process it, to accurately establish whether EITC claimants are eligible or not, and then correctly calculate the tax benefit? There’s no way of knowing the total overall cost for this data collection undertaking, but we can analyze the problem.
The IRS processed roughly 250 million personal,business, and related tax returns and 3.5 billion financial information returns in FY 2019, and handled 650 million online visits to IRS.gov. Against that backdrop, 25 million EITC recipients don’t seem like much of an extra burden.
But as noted above, the vast majority of those information returns are electronically generated and low-cost to handle. And the vast majority of the website visits are queries about the status of refunds and tax return transcripts, rather than the sort of interactive data entry that the EITC and CTC would require.
The Taxpayer First Act of 2019 did require the IRS to develop an internet portal by 2023 that allows taxpayers to electronically file 1099 forms for reporting income and other financial data, which are vastly simpler than the personal information collection that would be needed for the EITC. However, that process of development of a 1099 financial reporting portal is just starting, with Deloitte just recently receiving a 3-year contract to set up a project management office.
So we can reasonably expect that the EITC information return would have to be supplied via paper form submissions, at least for the foreseeable future, just as took place in the United Kingdom when the requirement was mandated there. One 2009 estimate by the Treasury Inspector General for Tax Administration put the cost of processing a paper tax return at $2.87 per return. But greatly complicating this type of undertaking is the fact that the IRS has gradually dismantled its paper return processing capacity over the last 20 years, with a residual capability that is a shadow of the legendary IRS paper processing operation in the first century of the IRS’s existence.
The Broader Context
This analysis, driven by the crisis of 2020 and the tax year to follow, raises the obvious question of why the IRS would set up an expensive new process to collect substantial personal information from EITC recipients, separate from the citizen’s actual tax return, which would have otherwise been submitted by the taxpayer in the normal voluntary compliance process. More generally, it does provide some insights into the costs of adopting return-free filing in an uncertain world and rapidly changing society. Return-free filing has often been thought of as a free lunch, where the IRS makes use of information that it already has to make life easier for low- and middle-income taxpayers and to save money. But the reality is starkly different from the rhetoric, and the often-claimed benefits for the working poor could in fact turn into another burden.
The IRS estimated that 25.3 percent ($17.4 billion) of the total EITC payments made in FY 2019 were “improper.” However, the IRS also estimated that approximately 21% of eligible taxpayers did not claim the credit that they deserve. That leads people to jump to the conclusion, as one journalist wrote, that “….Automatic filing would provide EITC payments to many of that 20 percent not getting them, and would spare taxpayers from doing complex calculations that sometimes lead to errors.”
But there are no secret troves of free data that are being hidden that would immediately translate into return-free filing, with fair and equitable treatment for the working poor and disadvantaged. One issue is that the United States has no official resident register that tracks where people are living. By comparison, many of the countries that have “return-free” filing are already tracking where people live through an official resident register. In Germany, often held up as a return-free filing example, the Federal Ministry of the Interior, Building and Community supervises an official resident register:
“Anyone who moves into a residence in Germany must register within two weeks of moving in. To register, you have to go to the registration authority of your municipality and present a valid ID card, passport or passport substitute document and a certificate issued by the person providing the residence.”
The U.S. does not maintain such official government requirements for registration of domicile. Drivers’ licenses, school records, healthcare records, and tax records could be used to assemble a partial picture, but not enough to fulfill the needs of the EITC.
Proponents of return-free filing argue that the IRS can use data already submitted by the taxpayer in the past. For example, Austan Goolsbee in 2006 proposed a Simple Return that “would use the taxpayer’s tax return information from the previous year.”
However, the 2020 example shows it’s just not possible to assess today’s residency from last year’s reports due to rapidly changing household units and relationships, and now especially with remote work and remote learning. The research by the TPC demonstrates that even in ‘normal’ times the increasing velocity of change in the makeup, location and relationships of American households, particularly among the working poor, is significant and government’s regulatory frameworks and definitions cannot keep up.
Moreover, these changes interact with the tricky rules for EITC eligibility. The Center for Budget and Policy Priorities notes that:
families’ living arrangements can be complicated, with working grandparents or aunts and uncles living with working parents and their children. More than one working adult in such families may potentially qualify to claim a given child for the EITC. Neither they nor, in many cases, their tax preparers may fully understand the complex rules that determine who is entitled to claim the EITC in such circumstances.
In the same vein, a report from the Tax Foundation observes that “improper payments are largely a result of the same child being claimed multiple times due to shared custody agreements or other complex living situations.”
Of course, the deeply layered complexity of the tax system doesn’t help either. The analysts at the Tax Policy Center write “If an income tax system were simple enough, the government could withhold taxes owed and do its own accounting at the end of the year without much help from taxpayers.” But what they mean by simple enough is a massive and comprehensive overhaul of the tax code, including a myriad of such fundamental changes as making the unit of taxation the individual rather than the family, and simplifying eligibility requirements for refundable credits.
The EITC and similar tax benefits such as the Child Tax Credit are hard cases for return-free filing just as a practical matter, because they require so much information which the IRS does not currently have. And prior year tax returns are no cure for ensuring accurate payment of future refundable credits, or avoidance of improper payments (either too little, or too much, or correct determination of eligibility for payment at all). The essence of accurately establishing annual eligibility is in its recognition of the greatly increased velocity of societal changes in the family unit, household makeup, human relationships, job changes, moving and other changed housing circumstances, and more, But they are also the cases that make a difference, because they directly affect the lives and economic well-being of so many low- and moderate-income Americans, because they are so complicated, and because there are so many mistakes, in both directions. And getting it right directly affects the economic condition of the people for whom refundable credits are intended as an anti-poverty lifeline.
There are no shortcuts. Precisely the people who need the help are those who would not benefit from return free filing. What 2020 shows us is that rather than giving these Americans extensive new forms to complete and file as a pre-return, or alternatively, to establish an intrusive new government national program of annual personal information collection, it is better to take that money and use it to improve the whole rickety IT infrastructure of the IRS in the performance of its core mission, which has been underfunded and woefully behind the IT and performance curve for decades.
Indeed, in a recently released paper PPI estimated that the federal government has an accumulated software investment deficit in excess of $200 billion. That is the extra amount that the federal government would have needed to invest in software to keep up with the private sector. Under these circumstances it’s difficult to justify diverting the IT funds to set up a “return-free” system that is actually not return-free for the low- and middle-income taxpayers who carry the burden of its complexity.
At its heart, this analysis of the Covid tax trap raises the broader question of the true societal cost for low- and moderate-income Americans in mandating a fundamental change in the nation’s voluntary compliance tax system that is touted as “reform”, “burden reduction,” and “cost reduction.” As we have shown here, the reality is quite different, and those adversely hit by the “return-free” proposal––making the government tax collector also the nation’s tax preparer––are the working poor and other low- and moderate-income Americans. These are the people with the least means, voice or resources to advocate for themselves, turning tax fairness and societal equity on its head.
